Estimation of Time-Varying Hedge Ratios for Corn and Soybeans:

BGARCH and Random Coefficient Approaches

Anil K. Bera
Department of Economics
University of Illinois at Urbana-Champaign

Philip Garcia
Department of Agricultural and Consumer Economics
University of Illinois at Urbana-Champaign

Jae-Sun Roh
Department of Agricultural Economics
Seoul National University

OFOR Paper Number 97-06

December 1997
 Estimation of Time-Varying Hedge Ratios for Corn and Soybeans:
BGARCH and Random Coefficient Approaches*

Anil K. Bera
Department of Economics
University of Illinois at Urbana-Champaign

Philip Garcia
Department of Agricultural and Consumer Economics
University of Illinois at Urbana-Champaign

Jae-Sun Roh
Department of Agricultural Economics
Seoul National University

Abstract

This paper deals with the estimation of optimal hedge ratios. A number of recent papers have
demonstrated that the ordinary least squares (OLS) method which gives constant hedge ratio is
inappropriate and recommended the use of bivariate autoregressive conditional heteroskedastic
(BGARCH) model. In this paper we introduce the use of a random coefficient autoregressive
(RCAR) model to estimate time varying hedge ratios. Using daily data of spot and futures prices
of corn and soybeans we find substantial presence of conditional heteroskedasticity, and also of
random coefficients in the regressions of return from the spot market on the return from the
futures markets. Hedging performance in terms of variance reduction of returns from alternative
models are also conducted. For our data set diagonal vech presentation of BGARCH model
provides the largest reduction in the variance of the return portfolio.

*
We are grateful to an anonymous referee whose suggestions led to improved exposition of the paper. We
benefitted from helpful discussions with Ray Leuthold and Paul Newbold. Theodore Bos and Ken Kroner
graciously provided some of the computer programs used in this paper. However, we retain the responsibility for
any remaining error. Financial support from the Research Board of the University of Illinois is gratefully
acknowledged.
 1. INTRODUCTION

Numerous approaches are available to estimate hedge ratios. Traditionally, ordinary least

squares (OLS) regression of the spot price on the futures price is run, with the slope coefficient

being the hedge ratio [e.g. Ederington (1979); Anderson and Danthine (1980)]. However, this

procedure is inappropriate because it ignores the heteroskedasticity often encountered in price

series [Park and Bera (1987)] and is not based on conditional information [Myers and Thompson

(1989)]. Recently, autoregressive conditional heteroskedastic (ARCH) [Engle (1982)] and

generalized ARCH (GARCH) [Bollerslev (1986)] have been used to estimate time-varying

hedge ratios (THR). The time-varying joint distribution of cash and future price changes has

been examined for hedging financial instruments [Cecchetti, Cumby and Figlewski (1988)].

Bivariate GARCH (BGARCH) models also have been used to estimate THR in commodity

futures [Baillie and Myers (1991); Myers (1991)], in foreign exchange futures [Kroner and

Sultan (1990)], in interest rate futures [Gagnon and Lypny (1995)], and in stock index futures

[Park and Switzer (1995) and Tong (1996)]. These more recent studies suggest that

conventional hedging procedures can produce misleading results.

The initial findings obtained using GARCH models raise several questions. First, what is

the sensitivity of THR to alternative specifications of the conditional covariance matrix, and

what tests can be used to select the most appropriate model? Second, what is the degree to

which the variance of returns is reduced with alternative procedures? Third, do alternative

approaches that effectively capture the time-varying nature of hedge ratios exist. The sensitivity

and degree to which time-varying hedge ratios reduce the variance of returns is important

because of the difficulty in specifying and estimating GARCH models. Due to the complex

structure of the covariance matrix, simplifying assumptions frequently are made to ensure non-

negative variances and tractable solutions. Testing procedures have not been used to identify the

1
most appropriate structure of the covariance matrix, and little empirical evidence exists

regarding the effects of the simplifying assumptions on estimated hedge ratios. This is of

particular importance, because while the limited evidence suggests that hedge ratios should be

considered time-varying, the effective reduction of the variance of returns generated by these

procedures over traditional constant hedge ratios has been small. Finally, alternative, more

tractable approaches may need to be examined; here, we propose the use of a random coefficient

(RC) model to estimate hedge ratios. The random coefficient approach has been successfully

used to identify systematic risk in the market model literature [e.g. Bos and Newbold (1984)] and

may prove useful in approximating effective hedge ratios.

In this article, we focus on model specification and empirical comparison of BGARCH

and random coefficient models for hedge ratio estimation. In the next section, the appropriate

hedging rule based on a mean-variance model is identified and alternative BGARCH models and

their estimation results are presented. Diagnostic tests are used to identify the appropriate model

specification. In Section 3, a random coefficient model for calculating THR is discussed and

estimated. The results from examining the hedging effectiveness of the ARCH-type and random

coefficient models, along with the conventional OLS hedging approach, are reported in Section

4. Finally, Section 5 offers some concluding remarks. Our analysis is similar to that of Baillie

and Myers (1991); however, there are some important differences. The data sets are different,

and we use nearby futures contracts. Our use of the random coefficient model in the context of

hedge ratio estimation is new, and three alternative versions of the BGARCH model are

considered. Finally, all our models are subjected to various diagnostic checks, specification tests

and model selection procedures.

2
 2. Time-Varying Hedge Ratios and Their Estimation Using BGARCH Models

2.1 The Time-Varying Hedging Rule

Using a mean-variance framework, hedge ratios have been estimated using OLS by

regressing the returns from holding a spot contract on returns from holding a futures contract. In

a similar context, assuming utility maximization and efficiency in future markets the conditional

optimal one-period ahead hedge ratio, b*t-1, at time t can be derived as

s f

Cov(Rt , Rt |
t1)
bt1  , (1)
f
Var(Rt |
t1)

where Rts and Rtf denote logarithmic differences of spot and futures prices from t-1 to t,

respectively and t-1 is the information set at time t-1. This ratio is similar to the conventional

hedge ratio except that the conditional variance and covariance replace their unconditional

counterparts. Because conditional moments can change as the information set is updated, the

hedge ratios also can change through time.

2.2 Specification of Selected BGARCH Models

The motivation behind using BGARCH models in the context of hedge ratio estimation is

that daily commodity future and spot prices react to the same information, and hence, have non-

zero covariances conditional on the available information set. We specify a general model as

s
Rt  µ s  st
f (2)
Rt  µ f  ft

t | t1
BN(0, Ht) , (3)

3
where Rts, Rts are defined above, t = (st, ft), BN denotes bivariate normal distribution, and Ht

is a time-varying 2x2 positive definite conditional covariance matrix. A somewhat general form

of Ht for a BGARCH (p,q) model can be written as,

q p
vech(Ht)vech(C)   ivech(t1t1)   Di vech(Ht1) , (4)
i1 i1

where C is a 2x2 positive definite symmetric matrix and i and Di are 3x3 matrices. The “vech”

operation stacks the lower triangular elements of a symmetric matrix in a column.

The parameterization given in (4) is difficult to estimate since positive definiteness of Ht

is not assured without imposing nonlinear parametric restrictions. Moreover, the model contains

too many parameters, e.g., for p=q=1, Ht has 21 parameters. Here, we examine several

simplifying specifications of Ht. One straightforward assumption that could be made is to

specify that a conditional variance depends only on its own lagged squared residuals and lagged

values. The assumption amounts to making  and D matrices diagonal. In this case, vech(Ht) of

a BGARCH(1,1) model is given by

2 2 2
hss, t cs ss 0 0 ss,t1 ss 0 0 hss,t1
vech(Ht) hsf,2 t  csf  0 sf 0 s,t1f,t1  0 sf 0 2
hsf,t1 . (5)
2
hff, t cf 0 0 ff 2
ff,t1 0 0 ff h 2
ff,t1

This form is called the “diagonal vech” representation of Ht. The necessary conditions for this

Ht to be positive definite are

2
cs > 0, cf > 0, cscf  csf > 0,
2 (6)
and ss > 0,ff > 0, ssff  sf > 0 .

4
Engle and Kroner (1995) suggested another parameterization which is almost guaranteed to be

positive definite. This form, the “positive definite” parameterization is written as

ss sf  ss sf 

2
css csf ss, t1 f, t1f, t1 ss sf ss sf
Ht    Ht1 . (7)
cfs cff fs ff f, t1s, t1
2
ff, t1 fs ff fs ff fs ff

Note that the number of parameters to be estimated for this specification is 11. When the  and

 parameters in the variance covariance function are zero, Ht becomes a constant conditional

covariance proposed by Myers and Thompson (1989),

css csf
Ht  . (8)
cfs cff

Bollerslev (1990) introduced another attractive way to simplify Ht. He assumed that the

conditional correlation between st and ft is constant over time and expressed Ht as

2 2
hss, t hsf, t hs,t 0 1 sf hs,t 0
Ht   , (9)
2 2
hfs, t hff, t 0 hf,t sf 1 0 hf,t

where sf (< 1) is the time-invariant correlation coefficient, and the individual variances h2s , t and

h2f , t are assumed to be a standard univariate GARCH process, for example,

2 2 2
hs, t  cs  sss, t1  sshs, t1.

It is clear that the “constant correlation” representation involves only 7 parameters. Also,

positive definiteness of the specification is assured if hs, t > 0 hf, t > 0. Because of these attractive

features, most of the applications of the BGARCH model use this representation [see for

example, Bollerslev (1990), Baillie and Bollerslev (1990), and Kroner and Sultan (1993)].

5
However, constancy of correlation is a very strong assumption and validity of model (9) remains

an empirical question.

2.3 Data and Selected Sample Statistics

Daily data of cash and futures prices for corn and soybeans are used for the period from

October 1988 to December 1989. The cash prices are central Illinois elevator bids. March, July,

November nearby futures contracts for soybeans, and March, July, December nearby futures

contracts for corn are used. The return on the futures and cash markets are defined as a

percentage change of each price, i.e.

Rist = 1000 log (Sit / Sit-1)

Rift = 1000 log (Fit / Fit-1),

where Sit and Fit refer to ith cash and futures prices respectively, and i is either corn or soybeans.

Switching to a nearby contract takes place on first day of the expiration month. The use of

nearby contracts is motivated by hedging practices in the grain industry. Day-to-day

purchasing/selling hedging activities, which our data and model best reflects, are most frequently

based on nearby contracts as opposed to more distant maturities. To reduce the possible effects

of discontinuities in the data series from using price differences between futures prices from

contracts with different maturities, changes in the futures prices for the nearby contract are

substituted into the data series on the day of the switch. While this may cause some problems as

the conditional variance for the new contract is specified in terms of past squared innovations

and conditional variances of the old contract, no appreciable differences were encountered in

examining the futures price series around the switch points. Similarly, examination of the

optimal hedging ratios around the switch points revealed little evidence of dramatic change in

their magnitudes. More importantly, since we use the same relevant data set in examining

6
alternative models, our comparative findings, which are the primary focus of the research, should

remain valid.

Several preliminary diagnostic tests on the return series of the data are conducted. Using

the Phillips-Perron unit root test, nonstationarity of the return series is examined. The unit root

hypotheses for the all return series of cash and futures of corn and soybeans are rejected (Table

1). The sample characteristics of univariate unconditional distribution of the return series of

corn and soybeans are summarized in Table 2. Not surprisingly, cash and futures returns for the

corn and soybeans show typical fat-tail non-normal distributions. In Table 3, test results on

autocorrelation of the series and bivariate normality are reported. The Ljung and Box Q statistic

is calculated to examine the autocorrelation of univariate return series. There is no evidence of

serial correlation. However, the Q2 statistics, based on squared return series, provide strong

evidence of conditional heteroskedasticity.

Bivariate normality is examined using the Bera-John (1983) omnibus test statistic

2 2
2
C3N(  Ti /6   (Tii3)2/24) , (10)
i1 i1

where N is a sample size and Ti = t[
i3]t /N, Tii = t[
i4]t /N, where
= R (X - m), X is the vector

of individual observation of a given return series, m is the mean of X, R is the matrix whose

eigen vectors are the same as the eigen vectors of the sample covariance matrix of X’s, but with

the eigen values raised to -1/2. Note that in the univariate case, Ti is the measure of skewness,

and Tii is the measure of kurtosis. Under the null hypothesis of bivariate normality, C3 is

asymptotically distributed as
2 with 4 degrees of freedom. Given the high values of the test

statistics bivariate normality is rejected soundly for both corn and soybeans return series.

7
2.4 Estimation Results

All parameters in the various BGARCH models are estimated using the maximum

likelihood method. The log likelihood function of BGARCH model is given by

1 T
1()   1 ()
T t1 t (11)
1
where 1t()  ½log(2)½log|Ht|½t Ht t

where
is the underlying parameter vector. The form of Ht depends on which specification of

the conditional variance is used. As discussed earlier, three specifications of Ht, namely positive

definite, diagonal vech, and constant correlation forms of BGARCH are estimated. As in most

of the applied work in ARCH, we use Berndt, Hall, Hall and Hausman (1974) algorithm

(BHHH) for maximizing 1(
).

The general model was estimated for all BGARCH specifications. In all cases, the

hypothesis that µ s= µ f = 0 could not be rejected. The results presented below reflect the

restricted model with no drift terms in (2). Restricting the model does not alter appreciably the

results from the BGARCH models. Other specifications, such as including a dummy variable for

daily effect and seasonal dummies were tried. However, estimates for dummy variables were

insignificant.

Tables 4 and 5 present the estimate results of the constant conditional covariance model

(equation 8) and the various BGARCH models for corn and soybeans, respectively. Likelihood

ratio (LR) statistics also are presented. Under the null hypothesis of conditional

homoskedasticity, the LR statistics are asymptotically distributed as

2(p) where p is the number

of extra parameters in the different BGARCH models. From the test results, it is clear that

conditional homoskedasticity is rejected overwhelmingly when tested against any of the

conditional heteroskedastic models.

8
 Now, consider the estimates of three heteroskedastic models. Most of the variance

parameters of constant correlation and diagonal vech models are significant and the values of the

estimated parameters seem to be quite reasonable. For the diagonal vech model, the conditions

for positive definiteness of Ht as stated in (6) are satisfied. Also, we note that for this model, the

estimates of ss + ss and ff + ff are all close to, but less than, one. On the other hand, in the

positive definite parameterization model, many of the parameter estimates are not significant. Of

course, it is not possible to choose a model just on the basis of significance and implications of

parameter estimates. For model selection, we subject the three BGARCH models to more

rigorous model testing. In the next section, we perform a number of diagnostic checks, such as,

conditional bivariate normality, autocorrelation and conditional heteroskedasticity tests, using

the standardized residuals obtained from the estimated models. Model selection criteria such as

Akiake’s Information Criteria (AIC) and Bayesian Information Criteria (BIC) are also used.

2.5 Model Specification Tests

Economic theory does not provide specific guidelines for the appropriate

parameterization of the BGARCH model. Therefore, the selection of an appropriate model is

essentially an empirical question. Based on the standardized residuals, t-1/2 ^ t from the constant

correlation, diagonal vech and positive definite parameterizations, we conduct the Ljung-Box Q,

Q2, and conditional normality tests. The results are reported in Table 6. For the constant

correlation model, as in the original data, we note from the Q statistic values that there is no

evidence of serial correlation in the residuals. The Q2 statistic, based on squared residuals,

provides an indirect test of conditional heteroskedasticity. None of the Q2 statistics are

significant, which contrasts sharply with the Q2 values for the return series reported in Table 3.

This indicates that the constant correlation model does take account of the conditional

heteroskedasticity present in the data. Finally, the Bera-John test statistics for bivariate

9
normality are much lower than those for the original series; for instance, for the original soybean

series, the test statistic was 1047.75. This was reduced to 243.21 for the standardized residuals.

However, all the statistics are still significant indicating that constant correlation BGARCH does

not take into account all the non-normality present in the data. Again, the primary source of

non-normality is the high kurtosis values.

The diagnostic test results for the diagonal vech and positive definite BGARCH models

also provide somewhat mixed results. All the skewness and kurtosis coefficients indicate that

the conditional distributions are still fat-tailed non-normal. The calculated Bera-John test,

rejects the null hypothesis of bivariate conditional normality for both the corn and soybean data.

However, the use of these BGARCH filters results in a significant reduction in the non-

normality. For example, the value of the Bera-John statistic, 563.16, for the unconditional

distribution of return series of corn is reduced to 87.61 and 34.44, respectively, for the diagonal

vech and positive definite representations. The Q(12) statistics indicate the absence of

autocorrelation for all the specifications. The Q2 (12) suggest that most of the heteroskedasticity

has been eliminated under the diagonal vech model, with only the soybean futures series

showing signs of a significant non-constant variance. However, the test results are less attractive

under the positive definite BGARCH representation; all series demonstrate significant non-

constant variances.

To assist in selecting an appropriate BGARCH specification, AIC and BIC are also

calculated, and are presented in Tables 4 and 5. For both corn and soybeans, the positive definite

parameterization has the smallest AIC and BIC values, followed rather closely by the diagonal

vech and the constant correlation models.

The overall selection of the most appropriate model, because of the mixed testing results,

must be made with care to balance the test findings. Based on the specifcation tests which favor

10
the diagonal vech and the constant correlation models, the model selection criteria which support

the positive definite and the diagonal vech models, and our previous concerns about the

parameter estimates of the positive definite form, the diagonal vech model appears to be

appropriate for the time-varying hedge ratio estimation for both corn and soybeans.

The BGARCH models provide the time-varying conditional variances and covariances of

Rst and Rft. Thus, the time-varying hedge ratio at time t-1 can be obtained from,

2

hsf,t
bt1   HRt . (12)
2
hff,t

The time-varying hedge ratios of corn and soybeans calculated from the above equation

are plotted in Figures 1-3. To save space we do not present the other THR graphs, but they are

quite similar. In Figures 1 and 2, the hedge ratios based on diagonal vech and constant

correlation BGARCH, and the constant hedge ratio estimates of 0.931 based on the OLS method

are illustrated for corn. The means and standard deviations of the time-varying hedge ratios of

constant correlation and diagonal vech BGARCH strategies for corn are 0.970 and 0.931, and

0.101 and 0.125 over the sample period. The estimated time-varying hedge ratios from the two

specifications demonstrate similar movements around its mean. In the case of soybeans (Figure

3), the constant hedge ratio from OLS is 0.897. The mean and standard deviation of time-

varying hedge ratios of the diagonal vech BGARCH model are 0.962 and 0.199 over sample

period. Unlike the case of corn, for soybeans, this sample mean is quite different from the OLS

hedge ratio. In Figure 3, the THR has one substantial drop at the beginning of the period

(October - November 1988) and high peak around July 1989. These large changes in the hedge

ratios occur near maturity of the harvest contracts (October - November) and during the summer

when the crops are most susceptible to the effects of weather.

11
 3. Comparison with Random Coefficient Model

The conventional hedge ratio model is given by

s f
Rt   Rt  t
(13)
t
i.i.d. N(0,2).

The primary objection to this model is the time invariance of the coefficient . Previously, we

discussed the use of ARCH models to capture the dynamic nature of hedge ratios. The random

coefficient (RC) model is another approach to take account of the time-varying nature of hedge

ratios and here we explore the possibility of using a RC model as an alternative to ARCH

models. In a different context, this type of model has been used before to estimate time-varying

coefficients. For example, Bos and Newbold (1984) used a RC model to estimate time-varying

systematic risk in the market model framework. A random coefficient autoregressive (RCAR)

model is written as

s f
R t   t R t  v t
(14)
(t  )  (t1 )  µ t ,

where t is a time-varying coefficient, and t and µ t are independent and identically distributed

random variables with means zero and variances 2 and 2µ respectively, and || < 1. When  =

0, the RCAR model is identical to the standard RC model of Hildreth and Houck (1968). The

parameters of the model can be estimated using the nonlinear maximum likelihood procedures

described in Pagan (1980). The estimated results are shown in Table 7 for corn and soybeans.

All parameter estimates for corn and soybeans are significant except the constant term .

An important issue here is to test for the constancy of the beta coefficient. When  in the

time-varying coefficient model (14) is not equal to zero, then testing H0 : µ 2 = 0 is complicated.

13
If the beta coefficient is not constant over time, under (14), Var (t) = µ 2/1-2. Under the null,

H0 : µ 2 = 0, the parameter  is not identified. Therefore, a test can not be conducted using the

conventional large sample tests such as the likelihood ratio, Rao’s score (RS), or Wald tests

because the nuisance parameter, , is identified only under alternative hypothesis. This

phenomenon results in a violation of regularity conditions for the standard testing procedures.

For example, in the formulation of the RS test, the information matrix derived from the

likelihood function with the restrictions of µ 2 = 0 becomes singular. Here, we follow the Davies

(1977) approach for testing µ 2 = 0. This procedure involves computing the standard RS statistic

for a given value of , say RS(). Then the test is based on a critical region of the form

{sup RS() > c} ,

(1,1) (15)

where c is a suitably chosen constant. Davies (1987) provided an approximation to the p-value

of the test [for a description of the computation of the p-value, see Bera and Higgins (1992)].

The supremum of the RS () for corn and soybeans are reached at  = - 0.76 and 0.28,

respectively. It is interesting to note that the corresponding maximum likelihood estimate of 

in Table 7 are -0.758 and 0.280. The p-values of the Davies test are very close to zero both for

corn and soybeans. Therefore, the null hypothesis of constant coefficient model is rejected for

both corn and soybeans.

The test of a RC model against the alternative of RCAR model is carried out with a LR

test under the following testable hypothesis,

H0 :   0
Ha :   0 . (16)

14
The calculated LR statistics are 15.699 and 4.169 for corn and soybeans respectively. Thus, the

null hypothesis, RC model, is rejected, although for soybeans the rejection is only at 5%

significance level.

These test results indicate that the RCAR model provides a good representation of the

data set. In order to trace time-variant hedge ratios, i.e., t, we employ a fixed interval

smoothing process using the following conditional means and variances of t over time period, t

= 1,2,...,T [see Newbold and Bos (1985, p. 39)]

 [t|Rs1...RsT; Rf1...RfT]
  (t|T) (17)
 (t|t)  At[(t1|T)  (t1|t)]

 Var [t|Rs1...RsT; Rf1...RfT]

 P(t|T)
 P(t|t)  At[P(t1|t)  P(t1|T)]At (18)
where At  P(t|t)P(t1|t)1 .

The smoothing process begins by setting t = T-1 in (17) and (18), thus obtaining the mean and

covariance of the conditional distribution of T-1. The maximum likelihood estimates, , , µ ,

2, presented in Table 7, are used for the fixed coefficient in the estimation of stochastic

parameter over sample period. The plots of t, time-varying hedge ratios for corn and soybeans,

are given in Figures 4 and 5, respectively. For corn, there is some similarity between the plots of

THR using RCAR model and those reported in Figures 2 and 3 using the BGARCH model;

although in Figure 4 we observe more fluctuation. For soybeans, quite interestingly, the

behavior THR obtained from BGARCH and RCAR models, as can be seen from Figures 3 and 5,

are very close.

15
 4. Hedging Performance of BGARCH and RCAR Models

The results of the diagnostic tests for that BGARCH and RCAR models led us to identify

alternative specifications for estimating the time-varying hedge ratios. However, the hedging

performance of the models still remains a practical question. We now investigate the in- and

out-of-sample hedging performance of the BGARCH and RCAR models. Under the assumption

that the time-varying conditional variance and covariance estimated from the diagonal vech

model is the generating process, the percentage reduction in the conditional variance of the

returns portfolio relative to the no hedging scenario is used to evaluate hedging performance. In-

sample results are based on the 311 observations used in the estimation process, while the out-of-

sample hedging performance is assessed over the next 60 observations.

The results of the in- and out-of-sample hedging performance are reported in Table 8.

For the corn, using the BGARCH models, the in-sample hedge performance is very similar, with

an average variance reduction of 79 percent. For soybeans, the BGARCH representations also

produce similar reductions in the variance of returns, except for the positive definitive

parameterization. The diagonal vech specification, which is somewhat a better model for our

data, provides the largest variance reduction, 79.42 and 77.00 percent reductions for corn and

soybeans, respectively. For both corn and soybeans, the RCAR model performs rather poorly,

reducing the corn and soybean variances by 73.70 and 73.23 percent, respectively, which is

inferior even to the constant hedging (OLS) procedure.

Out-of-sample results verify the attractiveness of the diagonal vech parameterization; its

use leads to the largest variance reductions for both commodities. The other BGARCH models

and the RCAR model perform very poorly; particularly the poor out-of-sample performance of

the positive definite model is quite unexpected.

16
 Overall, the results indicate the usefulness of appropriately specified BGARCH models

for establishing hedge ratios. These findings are consistent with Baillie and Myers (1991) but

somewhat different from Myers (1991) who encountered little difference in hedging performance

between time-varying and other procedures. Clearly, the disparate findings may be a result of

differences in the commodities and data, as well as the specification procedures employed here.

The results associated with the RCAR model framework caution against the use of a procedure

that does not directly specify and estimate the changing nature of variance matrix which is

fundamental to the measurement of time-varying hedge ratios.

While the BGARCH model shows potential for improved risk management, further study

is needed to assess the costs of its specification and implementation relative to the gains in

variance reduction. The implementation of the BGARCH framework can require frequent and

costly position changes in the futures market. In addition, the estimation and continual updating

of models for practical use can be time-consuming and costly. Assessment of the hedging

performance of these models in framework which explicitly incorporates these costs will provide

a more complete understanding of the usefulness of time-varying procedures for managing price

risk.

5. Conclusion and Further Research

Various BGARCH and RCAR models were applied to estimate time-varying hedge

ratios. This remedies the constancy of hedge ratios based on conventional OLS estimation and

permits the hedge ratios to be based on conditional information. After rigorous tests of model

specification, the diagonal vech parameterization was found to be appropriate for both corn and

soybeans. The BGARCH hedge ratios performed better at reducing the variance of the portfolio

return for corn and soybeans. A diagonal vech parameterization provided the largest reduction

in the variance of the portfolio return. This is consistent with the results of diagnostic and

17
specification test for the representation of conditional second moment. For both corn and

soybeans, the constancy hypothesis of the hedge ratio from OLS was rejected against random

coefficient autoregressive (RCAR) model. However, the RCAR model performed poorly at

reducing the variance of returns, perhaps, suggesting that this procedure may not be appropriate

in the presence of conditional heteroskedasticity. For our data Q2 statistics provide a strong

indication of conditional heteroskedasticity.

There are a number of issues that require further attention. In particular, the relationship

between the BGARCH and random coefficient models is an interesting issue. For our data set,

the performance of RCAR model is not very encouraging. However, from a theoretical point of

view, it is a viable alternative to the BGARCH model for estimating time-varying hedge ratios,

and perhaps would work better for other data sets. The fundamental difference between these

two models is that the BGARCH models consider the joint conditional distribution of the spot

and future prices while RC model specifies a conditional mean model for the spot price given the

futures price. In the RCAR model the time varying nature of the model is incorporated through

the mean equation and in BGARCH models, this is achieved through the variance specification.

It would be interesting to test BGARCH and RCAR models against each other directly using

Cox’s non-nested hypotheses testing procedures. Finally, from the behavior of the standardized

residuals, we noted that the BGARCH models under the assumption of conditional normality

does take account of most of the high degree of kurtosis in the data. However, some kurtosis

still remains unexplained. Therefore, use of a bivariate conditional t-distribution would seem to

be worthwhile.

18
Table 1. Phillips-Perron Test for Unit Roots of the Return Series

Corn Soybeans
Cash Futures Cash Futures
Z(t* ) -18.30 -17.39 -19.60 -15.92
Z(1) 167.98 151.82 244.14 91.85
Z(t~ ) -18.77 -17.94 -19.37 -17.22
Z(2) 131.70 129.86 216.40 115.92
Z(3) 111.64 101.16 210.76 43.07
Note:
Critical Values Z(t* ) Z(1) Z(t~ ) Z(2) Z(3)
1% -3.43 6.43 -3.96 8.27 6.09
5% -2.86 4.59 -3.66 6.25 4.68

The tests are based on the following regressions,

yt  µ

yt1  ut

~ ~ ~ ~
yt = µ +  (t - T/2) + yt-1 + ut

Z(t* ) test for H0 : * = 1

Z(1) test for H0 : µ* = 0, * = 1
~
Z(t~ ) test for H0 :  =1
~ ~ ~
Z(2) test for H0 : µ = 0,  = 1,  = 0
~ ~
Z(3) test for H0 :  = 1,  = 0

19
Table 2. Sample Statistics of the Return Series -- January 1989 - December 1990
Variable Mean Std. Dev. Skewness Kurtosis Minimum Maximum
Corn
Spot -.56 13.23 -.51 4.41 -56.05 37.18
Futures -.73 12.50 -.25 4.84 -50.06 43.34
Soybeans
Spot -1.14 14.39 -.61 4.22 -61.70 36.29
Futures -1.04 13.41 -.37 4.04 -46.80 43.68

Futures Contracts: Corn - May, July, December

Soybean - March, July, November

20
Table 3. Test Results of Autocorrelation and Bivariate Normality for the Return Series
Corn Soybean
Spot Futures Spot Futures
Q(12) 10.84 14.91 19.83 10.25
Q2(12) 35.04 52.41 39.30 35.45
Bivariate Normality
T1 -0.38 -0.23 -0.41 0.83
T11 4.40 9.38 3.87 11.75
C3 563.16 1047.75

T1 : Skewness
T11 : Kurtosis
C3 : Bera-John statistic,
Critical Values of
2(p) are:
1% 5%
p=4 13.277 9.488
p = 12 26.217 21.026

21
Table 4. Estimation Results of Alternative Models for Corn
BGARCH
Constant Constant Diagonal Vech Positive
Conditional Correlation Definite
Covariance
Css 176.257 23.936 68.418 29.921
(10.985) (6.808) (16.299) (13.936)
Cff 168.182 14.245 37.956 11.129
(11.106) (3.323) (10.575) (4.206)
Cfs 153.328 47.854 12.091
(3.001) (12.531) (6.705)
ss 0.136 0.197 0.770
(0.044) (0.053) (0.125)
sf 0.145 0.160
(0.430) (0.076)
fs -1.027
(0.151)
ff 0.121 0.132 -0.479
(0.019) (0.039) (0.101)
ss 0.738 0.454 0.341
(0.064) (0.102) (0.212)
sf 0.561 -0.012
(0.095) (0.165)
fs 0.507
(0.206)
ff 0.790 0.641 0.918
(0.022) (0.079) (0.153)
sf 0.887
(0.011)
Log Likelihood -2233.55 -2209.02 -2193.17 -2175.02
AIC 4432.04 4404.34 4372.04
BIC 4458.22 4437.99 4413.06
LR Statistics 49.08 80.76 117.06
[4] [6] [8]

The numbers in parentheses are standard errors. The AIC and BIC are the Akaike Information and the Bayesian
Information Criteria. The LR Statistics test the constant conditional covariance model (8) against the respective
BGARCH formulation. The numbers in brackets are the degrees of freedom, p. At the 1% level, the critical
2 [p]
are: 13.24 [4], 15.81 [6], and 20.09 [8].

22
Table 5. Estimation Results of Alternative Models for Soybeans

BGARCH
Constant Constant Diagonal Vech Positive
Conditional Correlation Definite
Covariance
Css 206.418 43.937 58.103 50.222
(13.691) (15.341) (10.183) (20.064)
Cff 180.204 31.477 37.862 47.140
(11.547) (11.664) (7.079) (25.029)
Cfs 161.755 45.811 48.176
(5.073) (7.836) (4.778)
ss 0.200 0.345 0.741
(0.037) (0.043) (0.119)
sf 0.314 -0.001
(0.043) (0.119)
fs -0.591
(0.128)
ff 0.133 0.304 0.239
(0.039) (0.048) (0.128)
ss 0.605 0.485 0.595
(0.090) (0.048) (0.933)
sf 0.543 -0.142
(0.040) (0.099)
fs 0.239
(0.079)
ff 0.703 0.589 0.951
(0.079) (0.043) (0.686)
sf 0.857
(0.010)
Log Likelihood -2322.59 -2294.14 -2181.97 -2166.10
AIC 4602.28 4381.94 4354.20
BIC 4628.46 4415.60 4395.34
LR Statistics 56.90 281.24 312.98
[4] [6] [8]

The numbers in parentheses are standard errors. The AIC and BIC are the Akaike Information and the Bayesian
Information Criteria. The LR Statistics test the constant conditional covariance model (8) against the respective
BGARCH formulation. The numbers in brackets are the degrees of freedom, p. At the 1% level, the critical
2 [p]
are: 13.28 [4], 16.81 [6], and 20.09 [8].

23
Table 6. Autocorrelation, Heteroskedasticity, and Conditional Normality Test Results for the Corn and Soybean BGARCH Models

Corn Soybean
Constant Diagonal Positive Constant Diagonal Positive
Correlation Vech Definite Correlation Vech Definite
Q(12)

st 9.15 19.08 10.84 17.92 12.31 20.33

ft 14.19 11.28 14.91 10.72 8.44 11.32
Q2(12)

2st 11.57 7.19 35.04 6.59 12.37 39.60

2ft 11.14 19.44 52.41 11.30 29.73 33.32
Conditional Bivariate Normality
Ts 0.17 0.05 0.24 -0.06 0.06 -0.03
Tf -0.63 -0.24 -0.28 -0.60 -0.45 -0.13
Tss 6.23 5.54 4.35 6.99 5.11 3.94
Tff 5.82 3.19 3.54 4.21 3.67 3.71
C3 261.16 87.61 34.44 243.21 74.37 18.88

Ts and Tf measure skewness of the standardized residuals, respectively for spot and future BGARCH models. Tss and Tff measure kurtosis. C3 is
the Bera-John statistic, 2 [4], where the critical values at the 1% and 5% levels are 13.28 and 9.49, respectively.

24
Table 7. Estimation Results of the Ordinary Least Squares and Random Coefficient Autoregressive Corn and Soybean Models

Corn Soybeans

OLS Rst = 0.126 + 0.931 Rft Rst = -0.128 + 0.897 Rft

(0.357) (0.029) (0.446) (0.029)

R2 = 0.774, D.W. = 2.26 R2 = 0.703, D.W. = 1.63

2 = 39.413 2 = 61.018
log likelihood = -1012.61 log likelihood = -1080.58

RCAR model Rst = 0.205 + t Rft Rst = -0.057 + t Rft

(0.319) (0.381)
t- 0.954 = -0.758 (t-1 - 0.954) t - 0.934 = 0.280 (t-1 - 0.934)
(0.029) (0.123) (0.029) (0.050) (0.134) (0.050)
2 = 27.283 2 = 30.070
(2.705) (3.860)
µ = 0.025 µ = 0.197
(0.015) (0.044)
log likelihood = -985.393 log likelihood = -1058.99

The standard errors are given in parentheses.

25
 Table 8. Performance Alternative Hedging Models Compared to No Hedging

Average Percentage Variance Reduction

from the No Hedge Position
Corn Soybean
In-sample Out-of-Sample In-Sample Out-of-Sample
Constant Hedging -77.42 -66.47 -73.97 -80.84
(Bivariate Conditional)
Constant Hedging -78.35 -67.70 -74.23 -80.80
(OLS)
BGARCH -78.75 -43.13 -73.90 -42.91
(Constant Correlation)
BGARCH -79.42 -69.61 -77.00 -85.69
(Diagonal Vech)
BGARCH -78.92 -0.87 -65.17 2.76
(Positive Definite)
RCAR model -73.70 -68.51 -73.23 -17.07

26
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